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METHODS OF SHARE & COMPANY VALUATION

(CHAPTER 3)

*OUTLINE: Price Earnings Ratio (P/E Ratio); Net Asset Method; Dividend (Valuation) Models; Discounted Future Profits; The Berliner Method of Free Cash Flow Method; and Note re Capital Asset Pricing Model (CAPM).

*INTRODUCTION We will look at company valuation in addition to share valuation. We will see that a number of different methods can be used to value a company. Valuations using these methods can often differ significantly from the total of shareholders funds on a company Statement of Financial Position.

*PRICE EARNINGS METHODMarket value per share = EPS x P/E ratio This is probably the most common and popular method to adopt when trying to value a company share.

This method calculates the value of a companys shares by using the following formula:

*Cont The P/E figure used depends upon: How secure the earnings of the company are the more secure the earnings, the higher the P/E ratio. Expectations of future profits the higher the expected earnings, the higher the P/E ratio. Companies which are unquoted generally have a P/E of between 50%. General financial and economic conditions.

*Cont The industry or industries which the firm is in and the prospects of those sectors. Liquidity and asset backing, including the nature of assets specialized assets with a restricted resale market may reduce the P/E ratio. The make-up of the shareholders and the financial status of any major shareholders. Companies dependent on one or two key individuals and their skills may have their P/E ratio lowered.

*NET ASSET METHOD With this method the company is viewed as being worth the total of its net assets and this makes the Statement of Financial Position the critical part of the business that is needed for share valuation purposes. If the share value is undertaken using this method, it is often necessary to update the Statement of Financial Position values, to ensure that the basis on which the valuation is done is as accurate as possible.

*Cont The problems include the following: Are the assets to be valued on a going concern or break-up basis? Are any assets covered by prior charges? How can the assets be valued is a professional valuation required? What are the costs of sale redundancy, taxation charges on disposal? Have all the liabilities been identified and correctly valued, including contingent liabilities?

*DIVIDEND (VALUATION) MODELS These models are based on the assumption that the market value of ordinary shares represents the sum of the expected future dividend flows, to infinity, discounted to present values.

The model used under this method varies with the assumptions used. The simplest model assumes that dividends will remain at a constant level in the future. The value of a companys shares can be calculated using the formula:

*ContModel of Dividend Growth

This model states:

where: Po = the current ex dividend market price do = the current dividend g = the expected annual growth in dividends r = the shareholders expected return on the shares

The expression do (1 + g) represents the expected dividend in the next year.

*ContDiscounting can be expressed as:

* This model can be expanded to allow for potential growth in the dividend rate, and can be simplified to the dividend growth model shown above:

*DISCOUNTED FUTURE PROFIT This method is sometimes used when a company intends to purchase anothers assets and invest in improvements in order to increase future profits.

*THE BERLINER METHOD OR FREE CASH FLOW METHOD This method is calculated by using the average of share prices obtained using the net assets method and the earnings methods. This method is also known as the free cash flow approach. The method may be difficult to adopt in practice as it needs forecasts of working capital and taxation to ensure that estimates of future cash flows and their timings are accurate.

*NOTE RE CAPM The Capital Asset Pricing Model (CAPM) is a further method of valuing shares. It is used especially to determine the required yield on equity when the shares are being priced before a Stock Market listing. We shall cover this topic in a later chapter, but we mention it here to remind you to include it in your revision of this stage.

THANKS FOR THE PARTICIPATION

Q & A*